How to set profit targets and control losses

The next phase of development of the trading system is to add risk management in the form of the initial stop loss (ISL). It provides a defined exit point should the market move against the position.

We use Maximum Adverse Excursion (MAE) analysis to help set this stop. MAE is the greatest distance, in points or ticks (depending on the contract), that the market moves against a trade when it is open. In the case of a losing trade, MAE can occur at the exit price. Recall that we collected MAE data from the basic system and performed a simple statistical analysis of that data: We measured the mean, median and standard deviation of the MAE data. That analysis will form the basis of our walk-forward optimization analysis to find the optimal stop loss.

The MAE data gathered from the backtest of the 4 a.m. entry time produced the following results:

It’s likely that the optimal initial stop loss will lie somewhere between the mean MAE values of winning and losing trades. Ideally, the optimal value will cut short the losses on the losing trades without prematurely exiting the winning trades. Of course, this is not going to be the case: Some trades that would have been profitable in the absence of an initial stop loss will be exited early; some losing trades that would have rebounded to a smaller loss will do the same. Trading is a series of compromises; our hope is to find the best one.